California was a signatory to the Multistate Tax Compact until June 28, 2012. The compact requires member states to offer their multistate taxpayers the option of using the compact’s three-factor formula to apportion and allocate income for state income tax purposes or a state’s own alternative apportionment formula.
Prior to 1993, California used a single method of apportioning and allocating income, the compact formula, which provided equal weight to three factors: property, payroll and sales. In 1993, it enacted legislation to give double weight to the sales factor for most business activity, notwithstanding the compact’s apportionment election provision.
On July 24, 2012, the California Court of Appeals ruled in Gillette Co. v. California Franchise Board that the compact is a valid multistate compact, adding that California is bound by it and its apportionment election provision unless and until California legislatively withdraws from the compact. Consequently, the taxpayer was entitled to refunds claimed using the compact’s formula to allocate income to California.
While the Gillette case was pending, California enacted legislation effective June 28, 2012, withdrawing from the compact. Even though California never acknowledged or informed taxpayers of the equally weighted apportionment election, and in an apparent attempt to limit its exposure to refund claims in case of an adverse decision, the legislation also provided: “The doctrine of election provides that an election affecting the computation of tax must be made on an original timely filed return for the taxable period for which the election is to apply and once made is binding.” The legislation said this did not constitute a change in existing law. Several commentators have questioned the validity of this legislation, as California Proposition 26 requires a two-thirds majority to pass any tax increase, which this legislation did not receive.
In an interesting twist, on August 9, 2012, the California Court of Appeals vacated its decision and ordered a rehearing “on its own motion and for good cause.” Whatever the rehearing decision, it is likely to be appealed to the California Supreme Court. However, in the meantime, taxpayers who would benefit from a single weighted California sales factor should consider filing protective refund claims. These refund claims would be considered protective due to the current level of uncertainty as to whether or not they will ultimately be allowed.
Although Gillette does not have precedential value outside California, the decision may lead to challenges in other states. There are 19 other states that are members of the compact: Alabama, Alaska, Arkansas, Colorado, District of Columbia, Hawaii, Idaho, Kansas, Michigan, Minnesota, Missouri, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah and Washington. Multistate businesses apportioning income to these states should review their filings in light of the Gillette decision.
For more information on the potential effects of this decision, contact your BKD state and local tax professional.